Mary Williams Walsh of the NYT reports, A New Plan for Valuing Pensions:

The board that writes accounting rules for states and cities has proposed a new approach for pension disclosures that falls far short of what some financial experts hoped, but which would still force many governments to highlight pension shortfalls they have played down.

The current standard has come under heavy fire from mainstream economists, who say it makes virtually all government pension benefits look less costly than they really are.

Government officials have granted pensions to teachers, police, judges and other public workers for years, without reflecting the true cost, analysts say. Now the bills are coming due, and in many cases there is not enough money set aside, adding to the fiscal distress across the country.

Pensions are a third-rail issue for the Governmental Accounting Standards Board, and it has been working with great deliberation. Its pension project began early in 2006 but is nowhere near completion. Earlier this month, the board issued a “Preliminary Views” statement, summarizing its conclusions so far and requesting public feedback. A new standard is unlikely to take effect until at least 2013.

Fiscal hawks have been urging the accounting board to require states to measure their pension obligations at fair value. Corporations already do this when they report their pension numbers to the Securities and Exchange Commission.

But state and local officials have resisted, and the Governmental Accounting Standards Board seems to have taken their objections to heart. Its new proposal would let them keep measuring their pension obligations the same way as before, with one big exception.

The rule makers want to shine a bright light on the states and local governments that routinely fail to put enough money into their pensions — places like Illinois, New Jersey and Pennsylvania — that year after year contribute less than their actuaries tell them they have to contribute to their pension funds. The accounting board wants those places to show the missing amounts on their balance sheets, not hide them in footnotes.

Further, instead of minimizing the shortfalls, those governments would have to calculate the shortfalls in a way that magnifies them.

“I think they hope this will be the disciplinary tool that will get everybody funding at the actuarial rate,” said Jeremy Gold, an actuary and economist who served on the accounting board’s pension advisory task force but who does not like the proposed new method. “They hope they will be punishing the real laggards.”

He said the board’s stated purpose was to foster correct financial reporting, not mete out punishment.

Many states and cities will be relieved at least that more far-reaching types of changes have been sidelined. They had feared a shift to fair value accounting in general and especially now, after big investment losses in 2008.

Some economists have been trying to strip down pension numbers to present something like fair value anyway. The most recent such study, by Eileen Norcross of the Mercatus Center at George Mason University and Andrew Biggs of the American Enterprise Institute, determined that if New Jersey’s state pension system disclosed its pension numbers at fair value, it would have a shortfall of $170 billion, instead of its reported $46 billion.

“This path is not sustainable,” Ms. Norcross said.

Governments and their actuaries argue that it is unfair and misleading to show them at their worst — or at any particular point in time. States and cities, after all, are fundamentally different from corporations — they do not do things like acquire each other or file for Chapter 11 bankruptcy protection.

In addition, while companies need to bring their pension funds to a standing stop and measure them during such events, governments never engage in such transactions, so they say there is no reason to disclose their financial status at a single time.

“I doubt anybody’s imagination is vivid enough to imagine the merger of states such as Kansas and Missouri, or Ohio and Michigan,” said Rick Roeder, an actuary and consultant in San Diego, in testimony submitted to the accounting board. “For a plan sponsor with a 50-plus-year time horizon, today’s market value can be anything but fair.”

At the heart of the dispute is the way governments gauge the value of the pensions they owe future retirees in today’s dollars — a commonplace financial calculation known as discounting. It is used to calculate things as diverse as bond prices and mortgages.

Discounting is based on an interest rate, which is supposed to reflect the riskiness and other attributes of the underlying asset. Current accounting rules tell governments to use the investment return they expect over the long term. In practice, this means most public pension funds now use about 8 percent.

Many economists criticize this practice, arguing that 8 percent reflects a fairly high degree of risk, though state pensions are guaranteed by law and are therefore virtually risk free.

Standard economic theory says they should be measured with a very low discount rate — something much closer to the rate on Treasury bonds than to the higher risk securities in most pension investment portfolios. These days, many economists think the states should be using a rate of about 4.5 percent to measure their pension obligations.

The difference — three or four percentage points — translates into hundreds of billions of dollars when applied to pension obligations.

The 50 states together reported pension obligations of $3.3 trillion as of mid-2008, and secured with assets of $2.3 trillion, according to the Pew Center on the States. But Ms. Norcross said that if the states had to report their pension obligations on a fair value basis, the number would have been $5.2 trillion.

What this means is that current liabilities of US public pension plans are heavily understated because they’re not calculated using the proper discount rate, the yield on Treasury bonds. Perhaps reporting pension obligations on a fair value basis is too onerous, but the alternative of using a higher discount rate based on an unrealistic long-term investment return is too generous and will ultimately leave taxpayers on the hook. When it comes to pension obligations, better to be safe than sorry.

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Mary Williams Walsh of the NYT reports, In Budget Crisis, States Take Aim at Pension Costs:

Many states are acknowledging this year that they have promised pensions they cannot afford and are cutting once-sacrosanct benefits, to appease taxpayers and attack budget deficits.

Illinois raised its retirement age to 67, the highest of any state, and capped the salary on which public pensions are figured at $106,800 a year, indexed for inflation. Arizona, New York, Missouri and Mississippi will make people work more years to earn pensions. Virginia is requiring employees to pay into the state pension fund for the first time. New Jersey will not give anyone pension credit unless they work at least 32 hours a week.

“We can’t afford to deny reality or delay action any longer,” said Gov. Pat Quinn of Illinois, adding that his state’s pension cuts, enacted in March, will save some $300 million in the first year alone.

But there is a catch: Nearly all of the cuts so far apply only to workers not yet hired. Though heralded as breakthrough reforms by state officials, the cuts phase in so slowly they are unlikely to save the weakest funds and keep them from running out of money. Some new rules may even hasten the demise of the funds they were meant to protect.

Lawmakers wanted to avoid legal battles or fights with unions, whose members can be influential voters. So they are allowing most public workers across the country to keep building up their pensions at the same rate as ever. The tens of thousands of workers now on Illinois’s payrolls, for instance, will still get to retire at 60 — and some will as young as 55.

One striking exception is Colorado, which has imposed cuts on its current workers, not just future hires, and even on people who have already retired. The retirees have sued to block the reduction.

Other states with shrinking funds and deep fiscal distress may be pushed in this direction and tempted to follow Colorado’s example in the coming years. Though most state officials believe they are legally bound to shield current workers from pension cuts, a Colorado victory could embolden them to be more aggressive.

Colorado pruned a 3.5 percent annual pension increase to 2 percent, concluding that was the fastest way to revive its pension fund, which was projected to run out of money by 2029. The cut may sound small, but it produces big results because it goes into effect immediately. State plans vary widely, but many have other costly features, like subsidized early-retirement benefits, which could likewise be trimmed for existing workers.

Despite its pension reform, Illinois is still in deep trouble. That vaunted $300 million in immediate savings? The state produced it by giving itself credit now for the much smaller checks it will send retirees many years in the future — people who must first be hired and then, for full benefits, work until age 67.

By recognizing those far-off savings right away, Illinois is letting itself put less money into its pension fund now, starting with $300 million this year.

That saves the state money, but it also weakens the pension fund, actually a family of funds, raising the risk of a collapse long before the real savings start to materialize.

“We’re within a few years of having some of the pension funds run out of money,” said R. Eden Martin, president of the Commercial Club of Chicago, a business group that has been warning of a “financial implosion” for several years. “Funding for the schools is going to be cut radically. Funding for Medicaid. As these things all mount up, there’s going to be a lot of outrage.”

Joshua D. Rauh, an associate professor of finance at Northwestern University who studies public pension funds, predicts that at the current rate, Illinois’s pension system could run out of money by 2018. He believes the funds of other troubled states — including New Jersey, Indiana and Connecticut — are also on track to run out of money in less than a decade, unless they make meaningful changes.

If a state pension fund ran out of money, the state would be legally bound to make good on retirees’ benefits. But paying public pensions straight out of general revenue would be ruinous. In Illinois’s case, it would consume about half the state’s cash every year, bringing other vital state services to a standstill.

Mr. Rauh said he thinks any state caught in that trap would have little choice but to seek a federal bailout. Bigger pension contributions and higher taxes can go only so far.

Many state officials, hoping for a huge recovery in the markets, say that such projections are too pessimistic, and that cutting benefits for future workers must suffice, given laws and provisions in state constitutions that make membership in a state pension fund a contractual relationship that cannot be breached.

Lawyers, though, are raising the possibility that those laws are being misinterpreted.

“It makes no sense to suggest that an employee who works for the state for a single day has acquired a right to have future pension benefits calculated for the next 20 to 40 years under whatever method was in effect on that single first day of service,” states a legal memorandum prepared for the Commercial Club of Chicago, which is concerned that a public pension collapse would badly damage the city’s business climate.

The club’s members include senior executives of big companies, like Boeing, Aon, Kraft, Motorola and I.B.M., that have frozen pensions or slowed the rates at which their workers build up benefits.

Some of those cuts set off titanic battles. The most famous was at I.B.M., which changed its pension plan just when many of its older workers were about to earn sharply higher retirement benefits. Aggrieved workers sued, but after a long battle, a federal appellate court found that the cuts were legal.

“An employer is free to move from one legal plan to another legal plan, provided that it does not diminish vested interests,” or the benefits workers have already earned, wrote Chief Judge Frank H. Easterbrook of the Seventh Circuit Court of Appeals in Chicago. He did not distinguish between corporate employers and states.

Colorado is basing its legal defense, in part, on a 1961 state supreme court ruling that said pension cuts for current workers were allowed if “actuarially necessary,” and will argue that it applies to retirees as well. Other states may not have such legal tools.

In California, Gov. Arnold Schwarzenegger has gone a different route, bargaining with the 12 unions that represent public employees. Last week four of them agreed to let the state cut its own contributions by requiring current workers to pay sharply more for the same pensions. The workers will contribute 10 percent of their pay, in some cases double the previous rate, to the state pension fund. Some other states are raising employee contributions as well, though less sharply.

In New Jersey, the administration of Gov. Christopher J. Christie recently imposed pension cuts on future hires, but has been quietly looking into whether it could also reduce the benefits that current employees expect to accumulate in the coming years.

“Can they change the benefit formula going forward? Sure. It’s not etched in stone,” said Edward Thomson III, an actuary and trustee of the New Jersey pension system who was asked to offer an opinion on whether New Jersey could adopt the federal pension law — the one that covers companies — as its governing statute.

A state assemblyman, Declan J. O’Scanlon Jr., recently introduced a bill to ratchet back a 9 percent pension increase that the state gave most workers in 2001.

“I think this will pass constitutional muster,” Mr. O’Scanlon said. “Otherwise, I fear the whole system will fall apart. Nine years — we’re out of money.”

Politics & pensions are never a good mix. And if you think this is just a US problem, think again. In Ireland, Fiona Reddan of the Irish Times reports that three-quarters of defined-benefit pension schemes in red. In England where Chancellor George Osborne just announced draconian 25% budget cuts, Tim Shipman of the Mail reports, Prepare for war of strikes over pay freeze and pensions say the public sector brothers.

I’ve been warning all of you to prepare for global pension war. It will hit private and public sector pensions, ruining retirement dreams, forcing workers to work longer than they planned for, solidifying deep antipathies that common workers have with the financial oligarchs who got away with billions in bonuses and bailouts. Politicians at the G20 be warned: hell hath no fury like a pensioner scorned.

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Bloomberg Businessweek reports, Baltimore proposes pension reforms; unions against:

Baltimore Mayor Stephanie Rawlings-Blake has proposed several changes to the pension system for police officers and firefighters.The city faces a $121 million budget deficit, and that number would balloon to $185 million without pension reform. Rawlings-Blake says the city can’t afford the cost of maintaining the current system.

Under the mayor’s plan, officers and firefighters would be forced to work 25 years, instead of 20, before they can retire with full pension benefits – about half their salary. The change would apply to officers and firefighters with less than 15 years of service.

The city police union opposes that change, saying it violates officers’ contracts. The police and firefighters’ unions have sued the city over its handling of the pension system.

The unions are not taking this sitting down. Julie Scharper of the Baltimore Sun reports, Police, fire unions sue city over pension:

Baltimore’s police and firefighters’ unions filed a lawsuit against the city in federal court Thursday, contending that officials “knowingly underfunded” their pension plan over the past decade — ignoring the advice of financial experts hired by the city.

The lawsuit threatens to introduce a protracted and costly legal battle into the emotionally charged debate about altering the retirement benefits paid to public safety officers.

If officials do not make drastic changes to the pension system by July 1, the city will owe $65 million that it cannot pay.

Union leaders, who stress the dangerous and grueling nature of police and fire work, have resisted the pension changes that the city has proposed, saying they constitute a violation of their contract.

“Some in city government are portraying this as a crisis,” said Bob Sledgeski, president of the firefighters union. “This has been long, ongoing neglect on the part of the city to follow their own experts’ advice. That’s not an accident, and 10 years does not a crisis make.”

City Council members, led by Helen L. Holton, chairwoman of the taxation and finance committee, have been scrambling for a solution to the pension problem before the fiscal year ends June 30.

Scores of police and firefighters have threatened to resign or retire if their benefits are significantly diminished. But city officials, grappling with a $121 million overall budget shortfall, say they cannot pay much more than the currently allotted $101 million pension contribution, although the city’s required obligations would be about $166 million if no changes are made in the way benefits are calculated.

The lawsuit, filed Thursday, names the mayor and City Council, pension board members, city finance director Edward J. Gallagher and public safety pension system director Thomas P. Taneyhill as defendants. In it, the unions allege that from 2003 to 2008, pension board members and city officials disregarded repeated recommendations by actuaries to reduce the pension fund’s assumed rate of return because it would have forced the city to contribute millions more to the plan.

Is this one of many lawsuits over mismanaged pensions? I think so. But the reality is that both the city and the unions will need to concede something as they try to resolve this issue. During times of fiscal restraint, there isn’t much of a choice.

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…the global pension crisis will not disappear overnight. It is a long-term structural issue that will plague governments for years. In fact, part of me thinks that the Fed and other central bankers will try to engineer inflation to partly offset future pension liabilities.

My worst fear is that they will fail miserably, creating another generation of paupers. I hope I am wrong, but this remains my worst fear for the next few years. I do hope monetary authorities and governments take the pension crisis more seriously.

Governments around the world are taking a closer look at pensions, especially public pensions, but I’m not convinced they’re moving in the right direction. I worry that instead of bolstering retirement systems around the world, we are weakening them, leaving far too many people exposed to the vagaries of “sophisticated” wolf markets. This virtually guarantees more pension poverty down the road.

As for monetary policy, the Fed continued engaging in quantitative easing (QE) in order to reflate risk assets and is engineering inflation, including inflation in emerging markets.

I still maintain that the financial oligarchs and power elite have vested interests to keep the current financial system alive for as long as possible. Their worst fear is to be trapped in a prolonged period of debt deflation. That’s why I still think the dips will be bought and that liquidity flows will continue driving risk assets higher in 2011.

But every year is different. The easy money was made in 2009 following post-deleveraging blues. Going forward, it will be much harder to make money off broad market moves, and deleveraging hasn’t gone away, but I also think the world isn’t half as bad as many bears scare us into believing.

Before you sell all your stocks or do anything extreme, take a step back and read some predictions for 2011. Let’s begin with Larry MacDonald who reports in CTV, Reasons to be both bullish and bearish in 2011:

In 1931, The New York Times celebrated its 80th anniversary by asking Henry Ford and other luminaries to forecast what the world would be like in 2011, another 80 years ahead. As the archives on the newspaper’s website reveal, Mr. Ford envisioned more success “in passing around the real profit of life.”

He may prove to be right. Investment strategists, most economists and investor sentiment surveys see higher stock markets and economic growth in 2011. But there are voices of dissent, or at least caution. Here are three reasons to be bullish for 2011 – and three reasons to be cautious.

Bullish: improving economic signals

Recent U.S. economic indicators hint that the self-sustaining phase of the business cycle may be close at hand. Retail sales have trended up since July to a three-year high, while jobless claims have declined, leaving the four-week average at its lowest point in nearly two and a half years.

The widely watched Weekly Leading Index published by the Economic Cycle Research Institute (ECRI) has risen to its best readings since May 28. Money supply and credit aggregates are turning up as well, observes institutional advisory BCA Research, suggesting banks are beginning to lend and firms to borrow.

Bearish: housing sector missing in action

Historically, the housing market leads U.S. economic recoveries. But stimulus so far has been “inadequate to lift home construction and sales,” reports Asha Bangalore, senior economist at the Northern Trust Company in Chicago.

Adding to concerns, the S&P/Case-Shiller Home Price Index has started to go down in recent months and could fall further. “There is still roughly two years of unsold inventory overhanging the market once the ‘shadow’ foreclosure backlog is included,” Gluskin Sheff chief economist David Rosenberg declares.

Bullish: supportive policy

Sparked by earlier fears of a double-dip recession, U.S. policy makers recently announced new measures to boost the economy. Bush-era tax cuts were maintained, the payroll tax temporarily cut by 2 per cent, and unemployment benefits extended.

The Federal Reserve announced a second round of quantitative easing, committing to the purchase of $600-billion (U.S.) in U.S. government bonds by June. The Fed wants to keep five- and 10-year Treasury yields down and encourage U.S. banks to lend rather than park funds in Treasuries, economists say.

Bearish: bond risk

If stimulus leads to growth quickening too much, the bond market could sell off, causing yields to shoot up and undermine the economy. The flash point is currently 3.8 per cent for 10-year U.S. Treasury yields, according to models developed by Peter Gibson, the CIBC World Markets chief portfolio strategist who has earned top rankings in the Brendan Wood International survey of analysts since 1994.

If yields breach this ceiling, the Fed will try to hammer them down with quantitative easing. If that doesn’t work, the Fed could raise short-term rates to appease the bond market with the prospect of economic slowdown, Mr. Gibson says.

Bullish: healthy corporations

U.S. corporations are “in phenomenal shape” writes Tony Boeckh in the Dec. 17 issue of the Boeckh Investment Letter. Profit margins, at 8.7 per cent, are way above the long-term average. And cash balances are huge, led by the technology sector with a cash-to-equity ratio that exceeds 25 per cent.

If the recovery picked up, “those cash holdings could be used for M&A activity, capital investment, share buybacks and, of course, higher dividend payouts,” Mr. Gibson writes. Exceptions may be exporters who keep cash balances offshore.

Bearish: state and local cutbacks

“One shock is the sharp pending drag from widespread and accelerating spending cutbacks and tax hikes at the fiscally strapped state and local government level [in the U.S],” Mr. Rosenberg points out. “This promises to be a major macro theme for 2011.”

Funding pressures are going to be more intense when the “Build America Bond” program winds up. “The sector has laid off 250,000 people in the past year and more is to come as this crucial 13-per-cent chunk of the economy moves further into downside mode,” he adds.

We continue on a bullish note which seems to be the consensus. Bob Doll, Chief Equity Strategist of BlackRock makes his 10 predictions for 2011:

1. US growth accelerates as US real GDP reaches a new all-time high.

2. The US economy creates two to three million jobs in 2011 as the unemployment rate falls to 9%.

3. US stocks experience a third year of double-digit percentage returns for the first time in more than a decade as earnings reach a new all-time high.

4. Stocks outperform bonds and cash.

5. The US stock market outperforms the MSCI World Index.

6. The United States, Germany and Brazil outperform Japan, Spain and China.

7. Commodities and emerging market currencies outperform the US dollar, the euro and the Japanese yen.

8. Strong balance sheets and free cash flow lead to significant increases in dividends, share buybacks, mergers and acquisitions and business reinvestment.

9. Investor capital flows move from bond funds to equity funds.

10. The 2012 Presidential campaign sees a plethora of Republican candidates while President Obama continues to move to the political center.

I tend to agree with most of these predictions, especially the ones I put in bold. One of the key things to watch for is how capital flows out of bond funds into equity funds. While stocks are likely to outperform bonds, I’m not bearish on bonds. I don’t see inflation in the US and backups in long bond yields present opportunities for investors to pounce.

Importantly, the Fed will do whatever it takes to make sure bond yields do not wreak havoc on the financial system. The problem is that some feel we didn’t need QE2 and there is way too much stimulus in the pipeline. Maybe the bond market is worried that another round of QE will propel yields higher. One portfolio manager told me: “we don’t need more QE; it’s going to backfire big time!”. The same portfolio manager sees the curve flattening in 2011 as short rates rise in anticipation of Fed rate hikes in 2012.

And what about Doll’s prediction that the US market will outperform all other markets? It might very well be the case, but Bernard Lapointe wrote an interesting comment in the Sceptical Market Observer claiming that 2011 may be the year for Japanese stocks. Who knows? I see liquidity flows continuing to drive US stocks higher.

As far as commodities, the biggest risk I see going forward is the price of oil overshooting $100/barrel. Forget the “imminent collapse of the euro zone” (won’t happen) and pay attention to oil because the biggest risk to the recovery is the price of energy. I remain bullish on energy and alternative energy where I see a long-term secular bull market developing (and potential bubble). Higher energy prices will be positive for the Canadian stock market.

Finally, listen to Barton Biggs, Traxis Partners and Jeffrey Gerson, Gerson Guarino & Meisel Group founding partner provide their predictions and outlook for 2011. Gerson says the housing double dip is likely to worsen in 2011 and will pressure the economy. Gerson is approaching the markets in a cautious and tactical manner because he believes the market is unlikely to regain the highs as soon as many might think.

Barton Biggs, however, is extremely bullish. Although he believes the market is overbought he says the market can continue to rally higher in the early portion of 2011. I agree with Biggs, especially on emerging markets, which is why I believe markets will climb the wall of worry.

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